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Buy Valeant Stock for a 45% Profit? 3 Things You Need to Know

Valeant Pharmaceuticals' (NYSE: VRX) stock is on a tear -- up nearly 17% so far this week, in the wake of a call with analysts in which the company detailed new plans to cut its debt load and improve its prospects.

It's a sharp turnaround for Valeant, which has lately seemed to go mostly down, not up -- down about 90% over the past 52 weeks, in fact. But according to one banker, today may be the beginning of a new and more encouraging trend for Valeant stock.

This morning, analysts at Morgan Stanley announced they are upgrading shares of Valeant from equalweight (hold) to overweight (buy), and assigning the stock a price target of $42 a share. That won't be enough to recover all of past investors' losses. But with Valeant shares currently trading for less than $29, it implies potential upside of 45% for new investors...if Morgan Stanley is right.

Here are three things you need to know.

"Can I interest you in some shares of Valeant Pharmaceuticals?" Image source: Getty Images.

1. "Severe financial stress"

Prior to its recent troubles, Valeant Pharmaceuticals was a stock on a tear, rising nearly 6 times in value as its revenue quadrupled over the four years running from August 2011 to August 2015. And yet, that revenue didn't bring much in the way of profits with it. Over the past five years, Valeant reported GAAP losses in three of the five -- losses big enough to erase all the profits earned in the two profitable years.

These problems got worse in the past year, with Valeant losing more than $1 billion over the past four reported quarters. Net debt leapt to well over $30 billion (on a $10.1 billion market cap). In a write-up on TheFly.com this morning, Morgan Stanley is said to characterize Valeant as a firm in "severe financial distress."

2. The debt's the thing

In fact, Valeant's debt load is probably the most stressful thing about the stock. But Morgan Stanley believes the debt is a fixable problem. According to the analyst, Valeant is working to renegotiate its debt covenants, improve cash flow, and use that cash to pay down debt.

Over time, Morgan believes that as debt levels decline, the stock's price will rise.

3. Is that realistic?

Now, paying down a debt load of $31.1 billion, with only $853 million cash in the bank to do it, might sound like a tall order -- especially for a company with no profits to work with. But while Valeant may lack profits as GAAP defines them, what it does have is copious free cash flows.

According to data from S&P Global Market Intelligence, Valeant generated in excess of $2 billion in cash profits over the past 12 months -- despite its reported $1 billion GAAP "loss." At current rates of FCF production, the company could conceivably pay off all of its debt...in 15 years. That's a long time to wait, of course. But it means that the debt problem is manageable if Valeant sets its mind to paying it off.

Final thing: Valuation

It does not necessarily mean, though, that you should follow Morgan Stanley's advice and buy Valeant stock. Here's why not:

Valued at $10.1 billion in market capitalization, once you include Valeant's debt load in the picture, the stock has an enterprise value of $41.3 billion. Divide the company's $2 billion free cash flow into that figure, and you come up with an enterprise-value-to-FCF ratio of 20.6. Meanwhile, most analysts who follow the stock only expect Valeant to grow its profits at about 11% annually over the next five years. The resulting EV/FCF/growth ratio of 1.9 seems mighty expensive -- and that's assuming most analysts are right about Valeant's growth prospects.

Last week, however, rival banker Wells Fargo pointed out that Valeant is projecting revenue growth of less than 2% annually from 2016 to 2018 -- less than half analysts' projected 4.3%. If Wells is right about that, then this would imply that even optimistic analysts such as Morgan Stanley may be wrong. And given that Valeant's value didn't look all that great to begin with, Wells' forecast gives you just one more reason to avoid this very troubled stock.

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Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 301 out of more than 75,000 rated members.